Taxes

Taxes

The toll booth analogy applies directly to any way in which governments collect money, with taxes being the most obvious example. The design of tax systems is the subject of a vast economic literature that you will be relieved to learn we will not attempt to summarize. The factors economists emphasize most are: incentives (how taxes alter behavior), equity (how much each person should pay), incidence (who actually pays for a particular tax), and compliance (to what extent people pay what they legally owe). All of these are obviously important, but to that list we would like to add sludge: how much time and effort is spent either complying with or evading a given tax. Although this subject is not ignored by either academics or policymakers, we think it is often given too little weight.

We believe that the American tax code is among the world leaders in sludge production. To give one example, the most commonly used tax form in the United States, Form 1040, came with a whopping 108 pages of instructions in 2019, and this was already slimmed down from the more than 200 pages a few years earlier.[14] The account reports that more than 94 percent of American filers paid a professional or used commercial software to prepare their tax returns, with average preparation taking about 13 hours and costing around $200 for their 1040s.[15] Meanwhile, in many other wealthy countries, filing your taxes is relatively painless.[16] The comparison reports that in Sweden, 80 percent of taxpayers filed their returns in minutes, free of charge, using their cell phones.

The sludge in the tax system can come simply from the straightforward task of attempting to follow the law as written, but it can also extend to the legal efforts to minimize one’s tax bill by taking advantage of myriad breaks to which the law says you are entitled. One of the problems is that whereas everyone is in favor of the principle of making the tax code simpler, groups organize to oppose getting rid of the particular tax breaks from which they benefit.

Even with the tax code monster that currently exists in America, it would be possible to eliminate vast amounts of sludge in one quick step suggested in 2006 by our friend, the economist Austan Goolsbee.[17] He suggests that the Internal Revenue Service (IRS)—which administers the income tax—should send as many people as possible a prefilled tax return, which taxpayers could easily file online by agreeing to the terms on a secure web page. This would be similar to the system used in Sweden. It turns out that nearly 90 percent of taxpayers would be able to use this service, because most Americans have very simple tax returns. Taxpayers have the choice between itemizing every deduction for which they are qualified (lots of sludge) or taking the standard deduction, which for a couple filing jointly in 2020 is $24,800. For any household whose income comes from their employers (that is, household members are not self-employed or business owners) and that chooses the standard deduction, the IRS has all the information it needs to calculate the tax bill. A recent increase in the standard deduction is the reason why so many taxpayers would be able to use this service.[18]

We should stress that preparing the prefilled tax returns would not create much new work for the IRS. Wage income is reported to the IRS by employers, and investment income is reported by banks and investment firms. The agency already knows how to compute tax bills because when you file your taxes, its computer programs check to see that your calculations match theirs. As we are writing, Canadian legislators have proposed a very similar plan.[19]

You may be wondering why such an obviously good idea has not already been adopted. Well, you can make a pretty good guess as to who would be opposed to such a bill: the companies that make money charging people for filing such a return! News bulletin: business lobbies can have a powerful effect on Congress. Rather than supporting a bill requiring the IRS to provide free returns, they convinced Congress to enact a bill forbidding it! In return, the tax preparation firms promised to do such returns for “free.” Of course, having to visit a physical or online service is not as easy as clicking “Yes,” and anyone who does so is quite likely to run into additional sludge, such as an offer for a tax refund loan, or a fee to do their state income tax return, which should also be done automatically.

There is another advantage of the auto-return model, which is that the government can make sure taxpayers apply for and receive any tax benefits to which they are entitled—but for which they are currently required to ask. The Earned Income Tax Credit is one example. This tax credit is intended to both encourage work and transfer income to the working poor. It has an assortment of short-term and long-term benefits for working people and their children. Where the IRS already has the information needed to establish eligibility, that information could help taxpayers claim the credit. Other cases may require details beyond income reports alone. But instead, many eligible taxpayers fail to fill in a required form to receive the payment, thus depriving themselves of the work subsidy that Congress intended they receive. The result is about 20 percent of people who are eligible for this very important benefit do not get anything at all.[20]

Short of auto-return, there is a lot that government can do to reduce the billions of hours now spent on complying with tax law. Simpler and shorter forms would help. In addition, anticipated sludge should be part of the analysis of any new tax proposals.

One example is the concept of a wealth tax, in which households are taxed on wealth they hold above some (high) threshold. For example, in the 2020 Democratic primary campaign, Senator Elizabeth Warren proposed the imposition of a wealth tax on households that have a net worth exceeding $50 million. Imposing the tax only on the very wealthy is sensible on the sludge front, since the vast majority of families would be exempt.

Don’t worry, we do not feel either qualified or inclined to analyze the overall merits of a wealth tax. We stipulate that the proportion of the wealth held by the highest 1 percent or 0.01 percent of households has risen greatly over time, and we understand and sympathize with the motivations for considering a tax on wealth to mitigate this rising inequality. But our concern here is sludge, and when it comes to a wealth tax, mountains of sludge would be unavoidable. The essential problem is that to impose a tax on wealth you have to know how much wealth someone has. This is not as easy as it may seem.

The simple cases are when most wealth is held in liquid market securities such as shares of publicly traded stock. The wealth that Jeff Bezos holds in shares of Amazon stock is easily measured. But what about the rest? Senator Warren was fond of saying on the campaign trail that she would tax the jewelry, art, and yachts owned by billionaires.[21] Let’s take art as an example of how hard this would be to do. There are two critical problems: we don’t know what art people have, and we don’t know what it is worth. There is no national (much less international) registry of artworks. In order to tax wealth, the IRS would have to know each piece of art held by every rich family, and its current market value.[*] Now think about jewelry, or stamps, or sports memorabilia.

Our goal here is not to have you shed a tear for the accountants and art dealers of billionaires. Rather, just think of the staffing requirements that would be needed to administer such a tax. Now, you might think we could reduce the sludge by limiting the tax to wealth held in liquid assets, but of course that would encourage the rich to put even more of their money into other forms of wealth, and might also induce more large companies to become privately held like Cargill or Fidelity Investments. They would be encouraged to do so because it is difficult to determine the value of a privately held business whose shares do not trade.

Our message is clear: every part of the tax system should be designed with a careful eye on the sludge burden. If the goal is to raise taxes on the ultrarich, we think taxing large inheritances as ordinary income is a more promising path. The estate tax offers another possibility, but it would need substantial reform because the current estate tax is written and enforced in a way that generates a high ratio of sludge to revenue.